China has slowly seen its current account surplus dwindle. In large part, this change from surplus to deficit has been driven by demographic forces. As a result of China’s previous ‘one child’ policy, enacted in 1979, the country is destined to grow old before it becomes rich, at least by Western standards. The one child policy has now been relaxed but, as yet, only a tiny percentage of parents have applied to have a second child. What does that mean for the prospects for Chinese assets and what might be the implications for the asset markets of its trading partners?

If China continues to meet its demographic challenge head-on, it might yet be able to grow old and rich at the same time.

During the last 70 years China’s average life expectancy has risen from 35 to 75 whilst its fertility rate has collapsed – it is now lower than France or the US. On current trend, 30% of China’s population will be over 60 by 2050 as the median age rises to 46 years. Nonetheless, this powerful trend has been tempered by rising female labour-force participation and educational improvements which have boosted productivity. Another factor, helping to offset the impact of ageing, is the rising number of beyond retirement age workers. These elements, though significant, remain insufficient to stop China’s working age population declining, according to the National Bureau of Statistics it peaked at 941 million in 2011.

Other emerging economies, especially India and Indonesia, continue to reap the demographic dividend, capturing market share in low-tech, labour intensive industries. Chinese exports have not vanished, however, India’s trade deficit with China hit US$62bln in 2017, even in the face of escalating Chinese labour costs. Cogniscent of its dwindling competitive advantage in unskilled labour, China has concentrated in adding value through technological investment to raise productivity further. As developed coastal regions become more high-tech, lower cost manufacturing industries have been relocated inland, capitalising on the continued flow of low-cost, unskilled rural workers, migrating to the cities.

China’s leaders are keen observers of the tide, where the country cannot compete in trade, it has become a prominent investor. Its focus has been on neighbouring countries such as Vietnam, Laos and Cambodia. It has also made significant strategic investments in resource rich, but economically underdeveloped, countries in regions such as Africa.

The demographic problems facing China are substantial. Pension deficits are rising, as are healthcare costs, meanwhile China’s high savings rate is finally beginning to diminish. In Deliotte’s Q3 2017 Insights report – Ageing Tigers, hidden dragons – the authors’ discuss a third wave of Asian growth, pointing to India and noting that China’s economic expansion, whilst still the largest contributor to world GDP growth in absolute terms, has been slowing for several years. The chart below shows the steep peak in China’s working age population around 2011; on current trend China’s average age will exceed the US by 2021 and equal that of Japan by 2045: –

Source: Deloitte

During the next decade, India’s working-age population will rise by 115mln: more than half of the 225mln expected increase across Asia as a whole. This is not just a Chinese problem, with the notable exception of Indonesia and Philippines, the ageing problem will also beset the rest of Asia, as the chart below makes clear: –

Current GDP per capita is a little under $10,000, against $40,000 in Japan, and $60,000 in the US. With its current median age, China is the world’s 67th oldest country, and a median age of 45 would make it the 6th oldest country in the world today, which seems a good criteria for being “old” in absolute terms. China hits this age around 2035. Defining “rich” is also difficult, but taking the poorest Western European economy as an example would require GDP per capita of around $20,000. Reaching $20,000 GDP per capita in real terms by 2035 would require annual income growth of nearly 5%, when growth is at 6.5% and slowing. Raising the income threshold to $30,000 would need annual growth of 8%, and $40,000 (modern Japan) would require 10% growth. Achieving US levels of $60,000 would require a herculean 13% rate. It seems highly likely that China will indeed become old before it becomes rich.

China has far to go – and India even further – before they reach the levels of income of the developed nations, but in China’s case, the rebalancing towards domestic consumption is beginning to transform a country which was once the epitome of a mercantilist exporter of manufactures.

Ignoring the blip in March 2018, China may run its first current account deficit since 1993 this year. In 2017 the current account surplus was 1.3% GDP, down from 1.8% in 2016. The ratio has been falling steadily from as high of 10% in 2007. To balance the books, the country will need to attract foreign investment; an acceleration in the policy of financial market liberalisation is likely to be embraced. The Economist expresses it like this: –

China’s decades of surpluses reflected the fact that for years it saved more than it invested. Thrifty households hoarded cash. The rise of great coastal manufacturing clusters meant exporters earned more revenues than even China could reinvest. But now that has begun to change. Consumers are splashing out on cars, smartphones and designer clothes. Chinese tourists are spending immense sums overseas. As the population grows older the national savings rate will fall further, because more people in retirement will draw down their savings.

…China will need to attract net capital inflows… has eased quotas for foreigners buying bonds and shares directly… Pension funds and mutual funds all over the world are considering increasing their exposure to China.

This chart shows the evolution of China’s gross saving rate as a ratio of GDP since 2006: –

Source: CEIC

The savings rate may be in decline but capital market liberalisation is not without risks, many Chinese have managed to extract money from China, despite capital controls; the real-estate markets of Australia, Canada and, to a lesser extent, London and New York, bear testament to this trend. Yet, to attract the substantial foreign investment that will be required, it is important for foreigners to feel confident that they can withdraw their investment. The Chinese authorities risk opening the flood gates. Despite the different conclusions they are likely to draw, Malaysia’s imposition of capital controls during the Asian crisis of 1998 remains fresh in the minds of Chinese officials and institutional investors alike.

Foreign Direct investment may be robust but far more will be needed as trade balances switches sign. February saw FDI in manufacturing rise 12%, whilst investment in high-tech manufacturing grew by a less stellar 9.3%.

For the Chinese authorities, another concern with liberalisation is the potential impact on many state owned enterprises. These heavily indebted behemoths are in a parlous position. Root and branch reform will be required to insure they do not precipitate financial, social and political instability.

The rest of the world will not be immune to the impact of China switching from current account surplus to deficit either. After the Japanese stopped investing their surplus earnings abroad the Chinese took up the gauntlet. Now that the flow of investment from China is diminishing, less economically developed countries, such as those of the African sub-continent, will find their infrastructure investments curtailed and their longer-term interest rates rising. The US Treasury will have to rely more heavily on it central bank to fill the void of Chinese investment dollars, but less developed countries will suffer. Other current account surplus countries will fill the investment void, but, unlike China, which has been investing for the long run, they are less likely to buy and hold over such an extended time horizon.

Conclusions and investment opportunities

China has spent many years sterilising the effect of its current account surplus by increasing official reserves. A large proportion of these reserves have been invested in US Treasuries, although latterly other developed government bond markets have benefitted from a move towards greater reserve diversification on the part of the Peoples Bank of China (PBoC).

As the current account switches sign from surplus to deficit, China will need to attract greater foreign investment to prevent its currency from declining. Relaxing of capital controls will be necessary to support the growing domestic consumption demand of an ageing populous. The risk for China is of greater domestic instability. They fear a flood of landlocked private savings being sent abroad, whilst inward fickle foreign investment offers a poor substitute, driven, as it is, by the need for short-term performance.

The solution to the PBoC’s capital conundrum is to adopt the policy levers favoured by developed nation central banks. Using quantitative techniques they can manage interest rates across the yield curve while Chinese capital markets steadily transform from a side-show into the main attraction. The transition will be uneven but the needs of a semi-affluent, ageing society are even more pressing than those of the deficit nations of the affluent developed world. Unlike Japan, whose international investments took the form of individual retirement savings, China’s external investments have been largely centrally directed. The needs of China’s ageing society, to draw down on savings, requires that the government replace domestic investment with foreign capital. To attract this capital to state owned enterprises will require more than just the relaxation of capital controls, it will require root and branch reform of these enterprises.

As China moves from an economic model of Communism with beauty spots to Capitalism with warts its outlook will inevitably become shorter-term, making asset markets will more volatile. The influence of its central bank will increase dramatically, as it adopts the policies of its developed nation peers. The overall pattern of international capital flows will become more fickle, to the detriment of less developed countries.

How are Chinese stocks responding to tariffs with the US and a slowdown in Asian growth?

Despite US tariffs, China’s September trade balance with the US reached a record high

A number of China’s Asian neighbours have seen a deceleration in growth

The Shanghai Composite has fallen more than 50% since 2015, the PE ratio is 7.2

Government bond yields have eased and the currency is lower against a rising US$

During 2018 Chinese financial markets have been on the move. 10yr bond yields rose from all-time lows throughout 2017 but have since declined: –

Source: Trading Economics, PRC Ministry of Finance

Despite this easing of monetary conditions the negative impact US tariffs, continues to weigh on the Chinese stock market: –

Source: Trading Economics, OTC, CFD

Despite being a leader in frontier technologies such as e-commerce (China has 733mln internet users compared with 391mln in India, 413mln in the EU and a mere 246mln in the US) the recent decline in tech giants Alibaba (BABA) and Tencent (TCEHY) have added to financial market woes. However, as the chart above shows, Chinese stocks have been in a bear-market since 2015. Some of its Asian neighbours have followed a similar trajectory as their economies have slowed in response to a US$ strength and US trade policy.

The notionally pegged Chinese currency has also weakened against the US$, testing it lowest levels in almost a decade: –

Source: Trading Economics

Meanwhile, President Xi has now announced plans to rebalance China’s economy towards consumption, turning it into an importing superpower. Surely something has to give.

The IMF expects Chinese GDP to grow at 6.6% in 2018. They continue to point to signs of economic progress: –

The country now accounts for one-third of global growth. Over 800 million people have been lifted out of poverty and the country has achieved upper middle-income status. China’s per capita GDP continues to converge to that of the United States, albeit at a more moderate pace in the last few years.

The authors go on to predict that the country may become the world’s largest economy by 2030. However, there are headwinds: –

Despite the sharp rebound in nominal GDP and industrial profits, total nonfinancial sector debt still rose significantly faster than nominal GDP growth in 2017. While the corporate debt to GDP ratio has stabilized, government and especially household debt is rising, driven by continued strong off-budget investment spending and a rapid increase in mortgage and consumer loans.

Raise investment. Beijing can engineer an increase in public-sector investment. In theory, private-sector investment can also be expanded, but in practice Chinese private-sector actors have been reluctant to increase investment, and it is hard to imagine that they would do so now in response to a forced contraction in China’s current account surplus.

Reduce savings by letting unemployment rise. Given that the contraction in China’s current account surplus is likely to be driven by a drop in exports, Beijing can allow unemployment to rise, which would automatically reduce the country’s savings rate.

Reduce savings by allowing debt to rise. Beijing can increase consumption by engineering a surge in consumer debt. A rising consumption share, of course, would mean a declining savings share.

Reduce savings by boosting Chinese household consumption. Beijing can boost the consumption share by increasing the share of GDP retained by ordinary Chinese households, those most likely to consume a large share of their increased income. Obviously, this would mean reducing the share of some low-consuming group—the rich, private businesses, state-owned enterprises (SOEs), or central or local governments.

Although fiscal stimulus appears to be rebounding it is a short-term solution. There have been many example of non-productive public investment: as a longer-term policy, this route is untenable: –

If Beijing does not rein in credit growth in time, it will be forced to do so once debt levels reach the point at which debt can no longer rise fast enough to maintain the country’s targeted economic growth rate. This adjustment can happen quickly, in the form of a debt crisis. Or (what I think is far more likely, at least for now) it can happen slowly, in the form of what is subsequently called a lost decade (or decades) of slow growth, similar to what Japan experienced after 1990.

Increased unemployment is a dangerous route to take, debt levels are already stretched, which leaves wealth transfers to the private sector.

A forced contraction in China’s current account surplus must be counteracted by either an increase in unemployment, an increase in the debt, or wealth transfers to Chines consumers (rather than savers).

Available data suggests that economic growth decelerated in the third quarter, mainly due to lackluster infrastructure investment and negative spillovers from financial deleveraging. Surprisingly, export growth remained robust in Q3 despite the ongoing trade war between China and the United States. The September PMI survey, however, revealed that external demand is softening, which suggests export figures are likely to worsen in the next few months. In response, the government has reverted to old tactics, boosting lending and increasing fiscal stimulus. Although these initiatives are effective in supporting the economy in the short-term, they threaten the effort made in previous years to reshape the country’s economic model and allow the country to avoid the “middle income trap”.

China Economic Growth

Looking ahead, economic growth is expected to decelerate. This reflects China’s more mature economic cycle and the impact of previous economic reforms, as well as the tit-for-tat trade war with the United States and the cooling housing market. However, a looser fiscal stance and a more accommodative monetary policy should cushion the slowdown. FocusEconomics panelists see the economy growing 6.3% in 2019, which is unchanged from last month’s forecast. In 2020 the economy is seen expanding 6.1%.

A widespread consensus has developed around the view that China’s economic growth is slowing and that the leadership in Beijing will have no choice but to capitulate in the tariff war with President Donald Trump to avoid a further slowdown. Leading US news organizations (here and here) have sounded this theme as a kind of late summer siren song to lull people into thinking that Trump’s confrontational approach is bound to succeed at some point. The reality is that, as has been the case for the last few years, the case for China’s imminent economic difficulties is overblown.

The most widely cited piece of evidence for the new conventional wisdom, for example, is that fixed asset investment is slowing dramatically. Unfortunately, this assessment is based on a monthly data series released by China’s National Bureau of Statistics (NBS), which is currently revising the method used to calculate fixed asset investment. The method that was used so far involved considerable double counting, which the authorities are paring back. The slowing growth of this metric, thus, tells us nothing, and assessments based on existing data are no longer meaningful.

There are three sources of growth in any economy: consumption, investment, and net exports. The problem is that data on China’s fixed asset investment, which include the value of sales of land and other assets, have increasingly overstated the expansion of the economy’s productive capacity. Nonetheless, financial analysts and others have relied on this series because it is the only high-frequency data available on investment. China’s data on gross domestic capital formation, which accurately measures the expansion of productive capacity, are available only on an annual basis and with a lag of five months.

According to NBS data, fixed asset investment grew by only 5.5 percent in the first seven months of 2018, the lowest in decades. In the first half of the year (January to June), fixed asset investment grew by 6 percent. But the price index for fixed asset investment rose by 5.7 percent, implying that real investment barely grew. This, however, is inconsistent with the more reliable NBS data, which show the expansion of capital formation, properly measured, accounted for about one-third of the 6.8 percent of China’s GDP growth.

When the NBS releases final data for 2018 (probably in about nine months), we are likely to learn that the growth of capital formation, properly measured, exceeded the growth of fixed asset investment, just as it did in 2017.

The full article is in three parts – part 2 – taking a closer look at domestic consumption – is here and part 3 – charting the steady rise in imports – is here.

Conclusions and Investment Opportunities

According to analysis from Star Capital (28-9-2018) the PE ratio for Chinese Stocks was just 7.2 times – the second cheapest of the 40 stock markets they monitor – although its CAPE ratio was a more exalted 15.7. Since June 2015 the Shanghai Composite Index have fallen by 53%, peak to trough, whilst since January it has retraced 32% to its low last month. The downtrend has yet to reverse, but, as the second chart above shows, we are testing a support line taken from the lows of 2005 and 2014.

The Q2 2018 Monetary Policy Report the PBoC revealed a moderation in the rate of growth of loans to households to 18.8%, other areas of lending continue to expand rapidly. M2 growth has been steady at around 8%. I believe they will allow interest rates to remain unchanged at 4.35%, or reduce them should the need arise. Last month PBoC foreign exchange reserves fell slightly (-$34bln) but they remain above $3trln: enough to moderate the RMBs decline. China’s real broad effective exchange rate (trade-weighted) is still in a broad, multi-year uptrend due to its soft peg to the US$. Here is the chart since 2006: –

Source: Federal Reserve Bank of St Louis

I expect China to reach a trade deal with the US within the next year. The recent slowdown in growth rate of debt formation by households will reverse: and the Shanghai Composite Index will form a base. The RMB may weaken further as the US continues to raise interest rates. Provided the US stock market maintains its nerve, an opportunity to buy Chinese stocks may emerge in the next few months. It may not yet be time to buy but there is little benefit in remaining short.

Federal Reserve tightening will continue, other Central Banks may follow

The bull market will be nine years old in March, the second longest in history

Since March 2009, the US stock market has been trending broadly higher. If we can continue to make new highs, or at least, not correct to the downside by more than 20%, until August of this year it will be the longest equity bull-market in US history.

The optimists continue to extrapolate from the unexpected strength of 2017 and predict another year of asset increases, but by many metrics the market is expensive and the risks of a significant correction are become more pronounced.

Equity volatility has been consistently low for the longest period in 60 years. Technical traders are, of course, long the market, but, due to the low level of the VIX, their stop-loss orders are unusually close the current market price. A small correction may trigger a violent flight to the safety of cash.

Meanwhile in Japan, after more than two decades of under-performance, the stock market has begun to play catch-up with its developed nation counterparts. Japanese stock valuation is not cheap, however, as the table below, which is sorted by the CAPE ratio, reveals:-

Source: Star Capital

Global economic growth surprised on the upside last year. For the first time since the great financial crisis, it appears that the Central Bankers experiment in balance sheet expansion has spilt over into the real-economy.

Since central banks began their B.S. back in 2001, when the Bank of Japan first began Quantitative Easing efforts, I’ve warned that it wouldn’t be enough… that none of them would be able to commit to the vast sums of money they’d ultimately need to prevent the Economic Winter Season – and its accompanying deflation – from rolling over us.

Are such high levels of artificial stimulus more important than demographic trends in spending, workforce growth, and productivity, which clearly dominated in the real economy before QE? Is global stimulus finally taking hold and are we on the verge of 3% to 4% growth again?…Fundamentals should still mean something in our economy…

And my Generational Spending Wave (immigration-adjusted births on a 46-year lag), which predicted the unprecedented boom from 1983 to 2007, as well as Japan’s longer-term crash of the 1990s forward, does point to improving trends in 2016 and 2017 assuming the peak spending has edged to 47 up for the Gen-Xers.

The declining births of the Gen-X generation (1962 – 1975) caused the slowdown in growth from 2008 forward after the Baby Boom peaked in late 2007, right on cue. But there was a brief, sharp surge in Gen-X births in 1969 and 1970. Forty-seven years later, there was a bump… right in 2016/17…

Source: Dent Research

The next wave down bottoms between 2020 and 2022 and doesn’t turn up strongly until 2025. The worst year of demographic decline should be 2019.

Japan has had a similar, albeit larger, surge in demographics against a longer-term downtrend.

Its Millennial generation brought an end to its demographic decline in spending in 2003. But the trends didn’t turn up more strongly until 2014, and now that they have, it’ll only last through 2020 before turning down dramatically again for decades…

Source: Dent Research

Prime Minister Abe is being credited with turning around Japan with his extreme acceleration in QE and his “three arrows” back in 2013. All that certainly would have an impact, but I don’t believe that’s what is most responsible for the improving trends. Rather, demographics is the key here as well, and this blip Japan is enjoying won’t last for more than three years!..

If demographics does still matter more, we should start to feel the power of demographics in the U.S. as we move into 2018.

If our economy starts to weaken for no obvious reason, and despite the new tax reform free lunch, then we will know that demographics still matter…

…a recent Bloomberg article noted that 40% of bitcoins are owned by around 1,000 or so individuals who mostly reside in the greater San Francisco Bay area (the early adopters). Sitting in Asia, it feels as if at least another 40% must be Chinese investors (looking to skirt capital controls), and Korean and Japanese momentum traders. After all, the general rule of thumb in Asia is that when things go up, investors should buy more.

Asia’s fondness for chasing rising asset prices means that it tends to have the best bubbles. To this day, nothing has topped the late 1980s Taiwanese bubble, although perhaps, left to its own devices, the bitcoin bubble may take on a truly Asian flavor and outstrip them all? Already in Japan, some 1mn individuals are thought to day-trade bitcoins, while 300,000 shops reportedly have the capacity to accept them for payment. In South Korea, which accounts for about 20% of daily volume in bitcoin and has three of the largest exchanges, bitcoin futures have now been banned. For its part, Korea’s justice ministry is considering legislation that would ban payments in bitcoin all together.

At the very least, it sounds like the Bank of Korea’s recent 25bp interest rate hike was not enough to tame Korean animal spirits. So will the unfolding bitcoin bubble trigger a change of policy from the BoK and, much more importantly, from the Bank of Japan in 2018?

Mr Gave then goes on to highlight the risks he perceives as under-priced for 2018, starting with the Bank of Japan:-

In recent years, the BoJ has been the most aggressive central bank, causing government bond yields to stay anchored close to zero across the curve, while acting as a “buyer of last resort” for equities by scooping up roughly three quarters of Japanese ETF shares. Yet, while equities have loved this intervention, Japanese insurers and banks have had a tougher time. Indeed, a chorus of voices is now calling for the BoJ to let the long end of the yield curve rise, if only to stop regional banks hitting the wall.

Source: Gavekal/Macrobond

So could the BoJ tighten monetary policy in 2018? This may be more of an open question than the market assumes. Indeed, the “short yen” trade is popular on the premise that the BoJ will be the last central bank to stop quantitative easing. But what if this isn’t the case?

The author then switches to highlight the pros and cons. It’s the cons which interest me:-

PPI is around 3%

The banks need a steeper yield curve to survive

The trade surplus is positive once again

The US administration has been pressuring Japan to encourage the Yen to rise

I doubt the risk of BoJ tightening is very great – they made the mistake of tightening too early on previous occasions to their cost. In any case, raising short-term rates will more likely lead to a yield curve inversion making the banks position even worse. The trade surplus remains small and the Yen remains remarkably strong by long-term comparisons.

This brings us to the author’s next key risk (which, given Gavekal’s deflationist credentials, is all the more remarkable) that inflation will surprise on the upside:-

Migrant workers are no longer pouring into Chinese cities. With about 60% of China’s citizens now living in urban areas, urbanization growth was always bound to slow. Combine that with China’s aging population and the fact that a rising share of rural residents are over 40 (and so less likely to move), and it seems clear that the deflationary pressure arising from China’s urban migration is set to abate.

Reduced excess capacity in China is real: from restrictions on coal mines, to the shuttering of shipyards and steel mills, Xi Jinping’s supply-side reforms have bitten. At the very least, some 10mn industrial workers have lost their jobs since Xi’s took office (note: there are roughly 12.5m manufacturing workers in the US today!).

Source: Gavekal/Macrobond

Source: Gavekal/Macrobond

To say that most “excess investment” China unleashed with its 2015-16 monetary and regulatory policy stimulus went into domestic real estate is only a mild exaggeration. Very little went into manufacturing capacity, which may explain why the price of goods exports from China has, after a five-year period, shown signs of breaking out on the upside. Another part of the puzzle is that Chinese producer prices are also rising, so it is perhaps not surprising that export prices have followed suit. The point is, if China’s export prices do rise in a concerted manner, it will happen when inflation data in the likes of Japan, the US and Germany are moving northward…

Source: Gavekal/Macrobond

Source: Gavekal/Macrobond

…The real reason I worry about inflation today is that inflation has the potential to seriously disrupt the happy policy status quo that has underpinned markets since the February 2016 Shanghai G20 meeting.

Mr Gave recalls the Plaza and Louvre accords of 1985 and ‘87, reminding us that the subsequent rise in bond yields in the summer of 1987 brought the 1980’s stock market bubble to an abrupt halt.

…for the past 18 months, I have espoused the idea that, after a big rise in foreign exchange uncertainty – triggered mostly by China with its summer 2015 devaluation, but also by Japan and its talk of helicopter money, and by the violent devaluation of the euro that followed the eurozone crisis – the big financial powers acted to calm foreign exchange markets after the February 2016 meeting of the G20 in Shanghai.

…as in the post-Louvre accord quarters, risk assets have broadly rallied hard. It’s all felt wonderful, if not quite as care-free as the mid-1980s. And as long as we live under this Shanghai accord, perhaps we should not look a gift horse in the mouth and continue to pile on risk?

This brings me to the nagging worry of “what if the Shanghai agreement comes to a brutal end as in 1987?”

Again the author is at pains to point out that, for the bubble to burst an inflation hawk is required. A Central Bank needs to assume the mantle of the Bundesbank of yesteryear. He anticipates it will be the PBoC:-

…(let’s face it: the last two upswings in global growth, namely 2009 and 2016, were triggered by China more than the US). Indeed, the People’s Bank of China may well be the new Bundesbank for the simple reason that most technocrats roaming the halls of power in Beijing were brought up in the Marxist church. And the first tenet of the Marxist faith is that historical events are shaped by economic forces, with inflation being the most powerful of these. From Marx’s perspective, Louis XVI would have kept his head, and his throne, had it not been for rapid food price inflation the years that preceded the French Revolution. And for a Chinese technocrat, the Tiananmen uprising of 1989 only happened because food price inflation was running at above 20%. For this reason, the one central bank that can be counted on to be decently hawkish against rising inflation, or at least more hawkish then others, is the PBoC.

Mr Gave foresees inflation delivering a potential a triple punch; lower valuations for asset markets, followed by tighter monetary and fiscal policy in China, which will then trigger an incendiary end to the unofficial ‘Shanghai Agreement’. In 1987 it was German Bunds which offered the safe haven, short-dated RMB bonds may be their counterpart in the ensuing crisis.

This brings our author to the vexed question of the way in which the Federal Reserve will respond. The consensus view is that it will be business as usual after the handover from Yellen to Powell, but what if it’s not?

…imagine a parallel universe, such that within a few months of being sworn in, Powell faces a US economy where:-

Unemployment is close to record lows and government debt stands at record highs, yet the federal government embarks on an oddly timed fiscal stimulus through across-the-board tax cuts.

Shortly afterwards, the government further compounds this stimulus with a large infrastructure spending bill.

As inflationary pressures intensify around the world (partly due to this US stimulus), the PBoC, BoJ and ECB adopt more hawkish positions than have been discounted by the market.

The unexpected tightening by non-US central banks leads other currencies higher, and the US dollar lower.

The combination of low interest rates, expansionary fiscal policy and a weaker dollar causes the US economy to properly overheat, forcing the Fed to tighten more aggressively than expected.

Gave proposes four scenarios:-

More of the same – along the lines of the current forecasts and ‘dot-plot’

A huge US fiscal stimulus forcing more aggressive tightening

An unexpected ‘shock’ either economic or geopolitical, leading to renewed QE

The Fed tightens but inflation accelerates and the rest of the world’s Central Banks tighten more than expected

…In the first two scenarios, the US dollar will likely rise, either a little, or a lot. In the latter two scenarios, the dollar would likely be very weak. So if this analysis is broadly correct, shorting the dollar should be a good “tail risk” policy. If the global economy rolls over and/or a shock appears, the dollar will weaken. And if global nominal GDP growth accelerates further from here, the dollar will also likely weaken. Being long the dollar is a bet that the current investment environment is sustained.

The final risk which the author assesses is the impact of rising oil prices. It has often been said that a rise in the price of oil is a tax on consumption. Louis-Vincent Gave gives us an excellent worked example:-

…assume that the world consumes 100mn barrels of oil a day…Then further assume that about 100 days of inventory is kept “in the system”… if the price of oil is US$60/bbl, then oil inventories will immobilize around US$600bn in working capital. But if the price drops to US$40/bbl, then the working capital needs of the broader energy industry drops by US$200bn.

The chart below shows the decline in true money supply:-

Source: Gavekal/Macrobond

The Baker Hughes US oil rig count jumped last week from 742 to 752 but it is still below the highs of last August and far below the 1609 count of October 2014. The break-even oil price for US producers is shown in the chart below:-

Source: Geopolitical Futures

If the global price of oil were entirely dependent on the marginal US producer, there would be little need to worry but the World Rig Count has also been slow to respond and Non-US producers are unable to bring additional rigs on-line as quickly, in response to price rises, as their US counterparts:-

Source: Baker Hughes

An additional concern for the oil price is the lack of capital investment over recent years. Many of the recent fracking wells in the US are depleting more rapidly. This once dynamic sector may have become less capable of reacting to the recent price increase. I’m not convinced, but a structurally higher oil price is a risk to consider.

Conclusion and investment opportunities

As Keynes famously said, ‘The markets can remain irrational longer than I can remain solvent.’ Global equity markets have commenced the year with gusto, but, after the second longest bull-market in history, it makes sense to be cautious. Growth stocks and Index tracking funds were the poster children of 2017. This year a more defensive approach is warranted, if only on the basis that lightening seldom strikes twice in the same place. Inflation may not become broad-based but industrial metals prices and freight rates have been rising since 2016. Oil has now broken out on the upside, monetary tightening and balance sheet reduction as the watch words of the leading Central Banks – even if most have failed to act thus far – these actions compel one to tread carefully.

A traditional value-based approach to stocks should be adopted. Japan may continue to play catch up with its developed nation peers – the demographic up-tick, mentioned by Dent research, suggests that the recent breakout may be sustained. The Federal Reserve is leading the reversal of the QE experiment, so the US stock market is probably most vulnerable, but the high correlations between global stock markets means that, if the US stock market catches a cold, the rest of the world is unlikely to avoid infection.

High-yield bonds have been the alternative to stocks for investors seeking income for several years. Direct lending and Private Debt funds have raised a record amount of assets in the past couple of years. If the stock market declines, credit spreads will widen and liquidity will diminish. In the US, short dated government bond yields have been rising steadily and yield curves have been flattening, nonetheless, high grade floating rate notes and T-Bills may be the only place to hide, especially if inflation should rise even as stocks collapse.

There will be a major stock market correction at some point, there always is. When, is still in doubt, but we are nearer the end of the bull-market than the beginning. Technical analysis suggests that one must remain long, but in the current low volatility environment it makes sense to use a trailing stop-loss to manage the potential downside risk. Many traders are adopting a similar strategy and the exit will be crowded when you reach the door. Expect slippage on your stop-loss, it’s a price worth paying to capture the second longest bull-market in history.

The PBoC has introduced targeted lending to SMEs and agricultural borrowers

Money supply growth is below target and continues to moderate

Chinese 10yr bond yields have been rising steadily since October 2016. They never reached the low or negative levels of Japan or Germany. 1yr bonds bottomed earlier at 1.76% in June 2015 having tested 1% back in 2009.

The pattern and path of Chinese rates is quite different from that of US Treasuries. Last month rates increased to their highest since 2014 and the Shanghai Composite index finally appears to have taken notice. The divergence, however, between Shanghai stocks and those of the US is worth investigating more closely.

The chart below shows the yield on 10yr Chinese Government Bonds since 2007 (LHS) and the 3 month inter-bank deposit rate over the same period (RHS):-

Source: Trading Economics

From a recent peak in 2014, yields declined steadily until October 2016, since when they have begun to rise quite sharply.

The next chart shows the change in yield of Government bonds and AAA Corporate bonds across the entire yeild curve:-

Source: PBoC

The dates I chose were 29th September – the day before the People’s Bank of China (PBoC) announced their targeted lending plan. The 22nd November – the day before the Shanghai index reversed and 6th December – bringing the data set up to date.

The general observation is simply that yields have risen across the maturity spectrum, but the next chart, showing the change in the spread between government and corporate paper reveals some additional nuances:-

Source: PBoC

Spreads have generally widened as monetary conditions have tightened. The widening has been most pronounced in the 30yr maturity. The widening of credit spreads may be driven by the prospect of $1trln of corporate debt which is due to mature between now and 2019.

Banks will enjoy 0.5 percentage point RRR cut if eligible lending exceeds 1.5 percent or more of their new lending in 2017

Deduction will be 1.5 percentage point if eligible lending reaches 10 percent or more of new lending in 2017, or if “inclusive finance” loans take up 10 percent of total outstanding loans in 2017

Rural commercial banks who meet an earlier requirement that at least 10 percent of new lending is local can receive a 1 percentage point reduction

The RRR is the Reserve Requirement Ratio. This is a targeted easing of lending requirements aimed at directing credit to small and medium sized enterprises (SMEs) rather than state owned enterprises (SOEs) and encouraging lending to the agricultural sector. It also favour banks over the shadow banking sector. This policy shift was a rapid response to a trend which has been evident this year. Whilst credit continues to expand the percentage of credit directed to SMEs dropped from 50% in 2016 to 30% in 2017 – this policy aims to rebalance the supply of credit.

Despite expectations that the first half of 2017 would be strongest, the Chinese economy continues to grow above official forecasts, Q3 GDP came in at 6.8%. M2 money supply growth, by contrast, was only 8.8% in October versus 9.2% in September. The chart below shows the declining pattern over the past five years:-

Source: CEIC, PBoC

8.8% M2 growth still looks high when compared with the US (6%) the EU (5.1%) or Japan (3.9%) but with GDP increasing by 6.8% it does not look excessive. It is worth noting, however, that the PBoC target for M2 growth in 2017 is 12% down from 13% in 2016.

What impact has this had on stocks? Not much, so far, is the answer:-

Source: Trading Economics, Shanghai SE

Chinese stocks, as I have mentioned previously, do not look excessively expensive by several measures, however, this is not to suggest that they will not fall. According to Star Capital, at the end of September the PE ratio for China was 7.6 but the CAPE ratio was a much higher 17.3. The Dividend yield (3.9%) offers some comfort nonetheless.

Conclusions and Investment Opportunities

Chinese economic growth remains spectacular but the authorities are interested in promoting inclusive growth rather than encouraging individual speculation. Official interest rates have been 4.35% since October 2015, which is the lowest they have ever been, however, the reverse repo rate was increased in January from 2.25% to 2.45% and the standing loan facility rate increased in March from 3.1% to 3.3%. The bond market expects this mild tightening bias to continue. Meanwhile, inflation, which was 1.9%, up from 0.8% in February, is hardly cause for concern.

Chinese stocks can be divided into SOEs and Non-SOEs. Since the beginning of 2017 the sectors have diverged sharply, as this chart of the WisdomTree China ex-State-Owned Enterprises Fund (CXSE) versus the MSCI China Index (NDEUCHF), indicates:-

Source: WisdomTree, MSCI

Even since the end of November, when stocks fell abruptly, the outperformance of, what some are calling new-China, has been maintained. This is not to suggest that PBoC policy is deliberately designed to support the new-China economy, but when the interests of the Chinese people and that of enterprises align it can be a winning combination.

It is still too soon to predict the end of the rise in Chinese stocks, the authorities, however, are determined not to allow a repeat of the speculative bubble of 2015. The combination of a continued decline in the pace of money supply growth and higher bond yields, may see Chinese stocks decline in response to monetary tightening before those of developed nation countries. Chinese stocks trade differently to those listed in more open markets, nonetheless, the importance of China should not be underestimated: it might even be the leading indicator for world markets.

For payments of principal that the Federal Reserve receives from maturing Treasury securities, the Committee anticipates that the cap will be $6 billion per month initially and will increase in steps of $6 billion at three-month intervals over 12 months until it reaches $30 billion per month.

For payments of principal that the Federal Reserve receives from its holdings of agency debt and mortgage-backed securities, the Committee anticipates that the cap will be $4 billion per month initially and will increase in steps of $4 billion at three-month intervals over 12 months until it reaches $20 billion per month.

The Committee also anticipates that the caps will remain in place once they reach their respective maximums so that the Federal Reserve’s securities holdings will continue to decline in a gradual and predictable manner until the Committee judges that the Federal Reserve is holding no more securities than necessary to implement monetary policy efficiently and effectively.

On the basis of their press release, the Fed balance sheet will shrink until it is nearer $2.5trln versus $4.4trln today. If they stick to their schedule that should take until the end of 2021.

The Fed is likely to be followed by the other major Central Banks (CBs) in due course. Their combined deleveraging is unlikely to go unnoticed in financial markets. What are the likely implications for bonds and stocks?

To begin here are a series of charts which tell the story of the Central Bankers’ response to the Great Recession:-

Source: Yardeni Research, Haver Analytics

Since 2008 the balance sheets of the four major CBs have grown from around $6.5trln to $18.4trln. In the case of the People’s Bank of China (PBoC), a reduction began in 2015. This took the form of a decline in its foreign exchange reserves in order to support the weakening RMB exchange rate against the US$. The next chart shows the path of Chinese FX reserves and the Shanghai Stock index since the beginning of 2014. Lagged response or coincidence? Your call:-

Source: Trading Economics

At a global level, the PBoC balance sheet reduction has been more than offset by the expansion of the balance sheets of the Bank of Japan (BoJ) and European Central Bank (ECB), however, a synchronous balance sheet contraction by all the major CBs is likely to be of considerable concern to financial market participants globally.

An historical perspective

Have CB balance sheets ever been as large as they are today? Indeed they have. The chart below which terminates in 2011, shows the evolution of the Fed balance sheet since its inception in 1913:-

Source: Federal Reserve, Haver Analytics

The increase in the size of the Fed balance sheet during the period of the Great Depression and WWII was related to a number of factors including: gold inflows, what Friedman and Schwartz termed “precautionary demand” for reserves by commercial banks, lack of alternative assets, changes in reserve requirements, expansion of income and war financing.

Outside of the recent past, excess reserves have only concerned policymakers in one other period: The Great Depression of the 1930s. This historical episode thus provides the only guidance about the Fed’s current predicament of how to unwind from the extensive Quantitative Easing program. Excess reserves in the 1930s were never actively unwound through a reduction in the monetary base. Nominal economic growth swelled required reserves while an exogenous reduction in monetary gold inflows due to war embargoes in Europe allowed banks to naturally reduce their excess reserves. Excess reserves fell rapidly in 1941 and would have unwound fully even without the entry of the United States into World War II. As such, policy tightening was at no point necessary and likely was even responsible for the 1937-1938 recession.

During the period from April 1937 to April 1938 the Dow Jones Industrial Average fell from 194 to 100. Monetarists, such as Friedman, blamed the recession on a tightening of money supply in 1936 and 1937. I don’t believe Friedman’s censure is lost on the FOMC today: past Fed Chair, Ben Bernanke, is regarded as one of the world’s leading authorities on the causes and policy errors of the Great Depression.

But is the size of a CB balance sheet a determinant of the direction of the stock market? A richer data set is to be found care of the Bank of England (BoE). They provide balance sheet data going back to 1694, although the chart below, care of FRED, starts in 1701:-

Source: Federal Reserve, Bank of England

The BoE really only became a CB, in the sense we might recognise today, as a result of the Banking Act of 1844 which granted it a monopoly on the issuance of bank notes. The chart below shows the performance of the FT-All Share Index since 1700 (please ignore the reference to the Pontifical change, this was the only chart, offering a sufficiently long history, which I was able to discover in the public domain):-

Source: The Stock Almanac

The first crisis to test the Bank’s resolve was the panic of 1857. During this period the UK stock market barely changed whilst the BoE balance sheet expanded by 21% between 1857 and 1859 to reach 10.5% of GDP: one might, however, argue that its actions were supportive.

The next crisis, the recession of 1867, was precipitated by the end of the American Civil War and, of more importance to the financial system, the demise of Overund and Gurney, “the Bankers Bank”, which was declared insolvent in 1866. Perhaps surprisingly, the stock market remained relatively calm and the BoE balance sheet expanded at a more modest 20% over the two years to 1858.

Financial markets became a little more interconnected during the Panic of 1873. This commenced with the “Gründerzeit” or “Founders” crash on the Vienna Stock Exchange. It sent shockwaves around the world. The UK stock market declined by 31% between 1873 and 1878. The BoE may have exacerbated the decline, its balance sheet contracted by 14% between 1873 and 1875. Thereafter the trend reversed, with an expansion of 30% over the next four years.

I am doubtful about the BoE balance sheet contraction between 1873 and 1875 being a policy mistake. 1873 was in fact the beginning of the period known as the Long Depression. It lasted until 1896. Nine years before the end of this 20 year depression the stock market bottomed (1887). It then rose by 74% over the next 11 years.

The First World War saw the stock market decline, reaching its low in 1917. From juncture it rallied, entirely ignoring the post-war recession of 1919 to 1921. Its momentum was only curtailed by the Great Crash of 1929 and subsequent Great Depression of 1930-1931.

Part of the blame for the severity of the Great Depression may be levelled at the BoE, its balance sheet expanded by 77% between 1928 and 1929. It then remained relatively stable despite Sterling’s departure from the Gold Standard in 1931 and only began to expand again in 1933 and 1934. Its balance sheet as a percentage of GDP was by this time at its highest since 1844, due to the decline in GDP rather than any determined effort to expand the balance sheet on the part of the Old Lady of Threadneedle Street. At the end of 1929 its balance sheet stood at £537mln, by the end of 1934 it had reached £630mln, an increase of just 17% over five traumatic years. The UK stock market, which had bottomed in 1931 – the level it had last traded in 1867 – proceeded to rally for the next five years.

Adjustment without tightening

History, on the basis of the data above, is ambivalent about the impact the size of a CB’s balance sheet has on the financial markets. It is but one of the factors which influences monetary conditions, the others are the availability of credit and its price.

…the Fed got by with what now seems like a modest-sized balance sheet, the liabilities of which consisted mainly of circulating Federal Reserve notes, supplemented by Treasury and GSE deposit balances and by bank reserve balances only slightly greater than the small amounts needed to meet banks’ legal reserve requirements. Because banks held few excess reserves, it took only modest adjustments to the size of the Fed’s balance sheet, achieved by means of open-market purchases or sales of short-term Treasury securities, to make credit more or less scarce, and thereby achieve the Fed’s immediate policy objectives. Specifically, by altering the supply of bank reserves, the Fed could influence the federal funds rate — the rate banks paid other banks to borrow reserves overnight — and so keep that rate on target.

Then comes the era of QE – the sea-change into something rich and strange. The purchase of long-term Treasuries and Mortgage Backed Securities is funded using the excess reserves of the commercial banks which are held with the Fed. As Selgin points out this means the Fed can no longer use the federal funds rate to influence short-term interest rates (the emphasis is mine):-

So how does the Fed control credit now? Instead of increasing or reducing the availability of credit by adding to or subtracting from the supply of Fed deposit balances, the Fed now loosens or tightens credit by controlling financial institutions’ demand for such balances using a pair of new monetary control devices. By paying interest on excess reserves (IOER), the Fed rewards banks for keeping balances beyond what they need to meet their legal requirements; and by making overnight reverse repurchase agreements (ON-RRP) with various GSEs and money-market funds, it gets those institutions to lend funds to it.

Between them the IOER rate and the implicit ON-RRP rate define the upper and lower limits, respectively, of an effective federal funds rate target “range,” because most of the limited trading that now goes on in the federal funds market consists of overnight lending by GSEs (and the Federal Home Loan Banks especially), which are not eligible for IOER, to ordinary banks, which are. By raising its administered rates, the Fed encourages other financial institutions to maintain larger balances with it, instead of trading those balances for other interest-earning assets. Monetary tightening thus takes the form of a reduced money multiplier, rather than a reduced monetary base.

Selgin goes on to describe this as Confiscatory Credit Control:-

…Because instead of limiting the overall availability of credit like it did in the past, the Fed now limits the credit available to other prospective borrowers by grabbing more for itself, which it then passes on to the U.S. Treasury and to housing agencies whose securities it purchases.

The good news is that the Fed can adjust its balance sheet with relative ease (emphasis mine):-

It’s only because the Fed has been paying IOER at rates exceeding those on many Treasury securities, and on short-term Treasury securities especially, that banks (especially large domestic and foreign banks) have chosen to hoard reserves. Even today, despite rate increases, the IOER rate of 75 basis points exceeds yields on most Treasury bills. Were it not for this difference, banks would trade their excess reserves for Treasury securities, causing unwanted Fed balances to be passed around like so many hot-potatoes, and creating new bank deposits in the process. Because more deposits means more required reserves, banks would eventually have no excess reserves to dispose of.

Phasing out ON-RRP, on the other hand, would eliminate the artificial boost that program has been giving to non-bank financial institutions’ demand for Fed balances.

Because phasing out ON-RRP makes more reserves available to banks, while reducing IOER rates reduces banks’ own demand for such reserves, both policies are expansionary. They don’t alter the total supply of Fed balances. Instead they serve to raise the money multiplier by adding to banks’ capacity and willingness to expand their own balance sheets by acquiring non-reserve assets. But this expansionary result is a feature, not a bug: as former Fed Vice Chairman Alan Blinder observed in December 2013, the greater the money multiplier, the more the Fed can shrink its balance sheet without over-tightening. In principle, so long as it sells enough securities, the Fed can reduce its ON-RRP and IOER rates, relative to prevailing market rates, without missing its ultimate policy targets.

Selgin expands, suggesting that if the Fed decide to announce a fixed schedule for adjustment (which they have) then they may employ another tool from their armoury, the Term Deposit Facility:-

…to the extent that the Fed’s gradual asset sales fail to adequately compensate for a multiplier revival brought about by its scaling-back of ON-RRP and IOER, the Fed can take up the slack by sufficiently raising the return on its Term Deposits.

And the Fed’s federal funds rate target? What happens to that? In the first place, as the Fed scales back on ON-RRP and IOER, by allowing the rates paid through these arrangements to decline relative to short-term Treasury rates, its administered rates will become increasingly irrelevant. The same changes, together with concurrent assets sales, will make the effective federal funds rate more relevant, by reducing banks’ excess reserves and increasing overnight borrowing. While the changes are ongoing, the Fed would continue to post administered rates; but it could also revive its pre-crisis practice of announcing a single-valued effective funds rate target. In time, the latter target could once again be more-or-less precisely met, making it unnecessary for the Fed to continue referring to any target range.

With unemployment falling and economic growth steady the Fed are expected to tighten monetary policy further but the balance sheet adjustment needs to be handled carefully, conditions may look benign but the Fed ultimately holds more of the nation’s deposits than at any time since the end of WWII. Bank lending (last at 1.6%) is anaemic at best, as the chart below makes clear:-

Source: Federal Reserve, Zero Hedge

The global perspective

The implications of balance sheet adjustment for the US have been discussed in detail but what about the rest of the world? In an FT Article – The end of global QE is fast approaching – Gavyn Davies of Fulcrum Asset Management makes some projections. He sees global QE reaching a plateau next year and then beginning to recede, his estimate for the Fed adjustment is slightly lower than the schedule announced last Wednesday:-

Source: FT, Fulcrum Asset Management

He then looks at the previous liquidity injections relative to GDP – don’t forget 2009 saw the world growth decline by -0.8%:-

Source: IMF, National Data, Haver Analytics, Fulcrum Asset Management

It is worth noting that the contraction of Emerging Market CB liquidity during 2016 was principally due to the PBoc reducing their foreign exchange reserves. The ECB reduction of 2013 – 2015 looks like a policy mistake which they are now at pains to rectify.

Finally Davies looks at the breakdown by institution. The BoJ continues to expand its balance sheet, rising above 100% of GDP, whilst eventually the ECB begins to adjust as it breaches 40%:-

Source: Haver Analytics, Fulcrum Asset Management

I am not as confident as Davies about the ECB’s ability to reverse QE. They were never able to implement a European equivalent of the US Emergency Economic Stabilization Act of 2008, which incorporated the Troubled Asset Relief Program – TARP and the bailout of Fannie Mae and Freddie Mac. Europe’s banking system remains inherently fragile.

ProPublica – Bailout Costs – gives a breakdown of cost of the US bailout. The policies have proved reasonable successful and at little cost the US tax payer. Since initiation in 2008 outflows have totalled $623.4bln whilst the inflows amount to $708.4bln: a net profit to the US government of $84.9bln. Of course, with $455bln of troubled assets still outstanding, there is still room for disappointment.

The effect of TARP was to unencumber commercial banks. Freed of their NPL’s they were able to provide new credit to the real economy once more. European banks remain saddled with an abundance of NPL’s; her governments have been unable to agree on a path to enlightenment.

Conclusions and Investment Opportunities

The chart below shows a selection of CB balance sheets as a percentage of GDP. It is up to the end of 2016:-

The BoJ has since then expanded its balance sheet to 95.5% and the ECB, to 32%. With the Chinese economy still expanding (6.9% March 2017) the PBoC has seen its ratio fall to 45.4%.

More important than the sheer scale of CB balance sheets, the global expansion has changed the way the world economy works. Combined CB balance sheets ($22trln) equal 21.5% of global GDP ($102.4trln). The assets held are predominantly government and agency bonds. The capital raised by these governments is then invested primarily in the public sector. The private sector has been progressively crowded out of the world economy ever since 2008.

In some ways this crowding out of the private sector is similar to the impact of the New Deal era of 1930’s America. The private sector needs to regain pre-eminence but the transition is likely to be slow and uneven. The tide may be about to turn but the chance for policy mistakes, as flows reverse, is extremely high.

For stock markets the transition to QT – quantitative tightening – may be neutral but the risks are on the downside. For government bond markets there are similar concerns: who will buy the bonds the CBs need to sell? If interest rates normalise will governments be forced to tighten their belts? Will the private sector be in a position to fill the vacuum created by reduced public spending, if they do?

There is an additional risk. Yield curve flattening. Banks borrow short and lend long. When yield curves are positively sloped they can quickly recapitalise their balance sheets: when yield curves are flat, or worse still inverted, they cannot. Increases in reserve requirements have made government bonds much more attractive to hold than other securities or loans. The Commercial Bank Loan Creation chart above may be seen as a warning signal. The mechanism by which CBs foster credit expansion in the real economy is still broken. A tapering or an adjustment of CB balance sheets, combined with a tightening of monetary policy, may have profound unintended consequences which will be magnified by a severe shakeout in over-extended stock and bond markets. Caveat emptor.

The price of Iron Ore, Aluminium and other industrial metals has rallied sharply over the last few weeks – WTI now seems to have followed suit. Most commentators regard this as a short covering rally.

Over the last six months the US economy has maintaining momentum, albeit at a disappointingly modest pace. Elsewhere the economic headwinds are blowing harder, with Europe and Japan still mired in a “slow-growth/no-growth” environment. Yet during the last few weeks the spot price of premium coking coal – one of the key inputs for steel production – has doubled to more than $200/tonne. Although this is from multi-year lows seen in 2015, coking coal is now the top performing commodity market year to date:-

The rise in the price of coking is upending the economics of the iron ore and steel markets with the Australian export benchmark price climbing 164% so far this year.

Metallurgical coal was exchanging hands at $206.40 on Monday according to data provided by Steel Index as it consolidates at higher levels following weeks of panic buying not seen since 2011, when floods in key export region in Queensland sent the price surging to $335 a tonne (albeit not for long).

The rally was triggered by Beijing’s decision to limit coal mines’ operating days to 276 or fewer a year from 330 before as it seeks to restructure the industry. Safety closures and weather related supply curbs in China and Australia only added fuel to the fire.

Source: TSI, Bloomberg, SGX

The price of Iron Ore has also risen by 31% to around $55/tonne, but, as the chart above makes clear, the ratio between the price of iron ore and coking coal is now at its lowest this century.

China’s coking coal output has fallen more than 10% due to the government edict to curtail domestic production. In response import volumes rose 45% in August alone. Goldman Sachs and Macquarie have both increased their price forecasts for 2017 and 2018.

The National Development and Reform Commission (NDRC) – the agency responsible for implementing production cuts – had achieved only 39% of the annual target for reducing coal capacity and 47% of the annual reduction in steel capacity as of the end of July. The Peterson – Institute – State of Play in the Chinese Steel Industry explains the reasons for this policy. Suffice to say, China’s domestic steel production tripled between 2005 and 2015 taking its share of global steel production from 31% to 50%. Under WTO rules it will have Market Economy Status from December 2016 – a wave of anti-dumping laws suits may well follow unless it curtails production.

Despite common knowledge of official policy, commentators have suggested that the recent production cut was intended to deliberately squeeze coal prices, allowing heavily indebted coal producers to repay loans to domestic Chinese banks. After two meetings between the China Iron and Steel Association and the NDRC, coal producers will now be allowed to produce an additional 50 tonne/day from October to alleviate shortages.

The steel industry was under margin pressure even before the rise in coal prices – the government has been forcing an industry wide consolidation. The high price of coal accelerates this “oligopolisation” of the sector. It is part of a broader reform and consolidation of State Owned Enterprises (SOEs). The Peterson Institute – China’s SOE Reform—The Wrong Path takes issue with this policy. It has its attractions in the short-term nonetheless – consolidation reduces competition within industries, the pricing power of these consolidated “oligopolies” should rise, enabling them to increase profitability and reduce their indebtedness. President Xi has called for “Stronger, bigger, better” state-owned enterprises. I fear for the squeezed private sector in this environment.

A more important structural reform was announced last month when the Supreme People’s Court ordered the establishment of more special divisions to handle liquidation and bankruptcy cases in intermediate courts. China has an undeveloped bankruptcy code – defaulting borrowers linger, acting as a drag on the economy. At the G20 summit President Xi said, “China has taken the most robust and solid measures in cutting excess capacity and we will honour our commitment with actions”. An efficient method of “zombie corporation liquidation” would expedite this process.

China’s coal consumption grew from 1.36 billion tons per year in 2000 to 4.24 billion tons per year in 2013, an annual growth rate of 12 percent. As of 2015, the country accounts for approximately 50 percent of global demand for coal. In other words, China’s economic miracle was fueled primarily by coal.

…China’s coal consumption decreased by 2.9 percent in 2014 and 3.6 percent in 2015, and the economy has maintained a moderate speed of growth. This indicates that there is a decoupling of economic growth from the growth in coal consumption. China’s coal consumption might have in fact already peaked.

Over the past 35 years, coal powered the engine of China’s rapidly developing economy. Coal represented 75 percent of overall energy consumption. This number decreased to 64.4 percent in 2015—the lowest in China’s modern history—as the country’s energy intensity decreased by 65 percent relative to 35 years ago. In fact, though rarely noticed until the recent peak, this has been part of a fundamental shift in the Chinese economy’s relationship with coal.

The authors present three arguments to support their view that China’s reliance on coal is in structural decline. Firstly, a decrease in manufacturing and construction, which have seen over-investment during the last decade or more. Second, policies on climate change and air pollution—especially the Paris Agreement’s, signed this month, which calls for a 20% clean energy target by 2030. Read China-United States Exchange Foundation – After the Paris Climate Agreement, What’s Next? for more details. Finally, China’s adoption of technological innovation in energy, communications, and manufacturing.

The total amount of water resources in China is so huge as to reach 2325.85 billion cubic meters, which is the 4th largest in the world. However, Chinese population is so large that the per capita amount of water resources is only 1730.4 cubic meters. This is extremely small in the world. Moreover, water resources are distributed unevenly by the region. Generally speaking, water is scarce in northern parts of China, including the Northeast, the North, and the Northwest regions. Beijing is in the North region. On the other hand, water is abundant in the South Central, the South, and the Southwest regions. The problem is that water is growing scarcer, while its consumption is rising. Particularly, people in Northwest China suffer from chronic shortage of water.

…It is not the quantity of water that matters critically in China. The quality of water is deteriorating rapidly. According to “The Monthly Report of Ground Water” which was released by the Ministry of Water Resources of China this January, they conducted water quality observation researches of 2,103 wells in the Songliao plain of the Northeast region and the Jianghan plain in an inland area last year, and it turned out that 80% of ground water is too severely contaminated to drink. Ground water pollution is serious, particularly in the regions of water scarcity.

In the shorter-term there has been some increase in demand. Steel usage has risen in response to the mini-stimulus package implemented in April. It was aimed largely at railway and housing construction. Electricity demand picked up again in May +2.1% from April +1.9%, fuelling an increase in demand for thermal coal. Other leading indicators, also suggest that the slowdown in Chinese growth may have run its course. There has been an increase in railway freight volumes and pickup in copper output:-

Source: Market Realist, National Bureau of Statistics

Outside China the picture looks mixed. LME stocks of Copper and Zinc have recovered but Nickle and Aluminium stocks remain depleted. Global demand still appears to be subdued.

Chinese economy is unlikely to return to the double digit growth rates seen prior to the great recession, but, despite its indebtedness, the world’s largest command economy may be able to avoid an imminent banking crisis.

The Debt to GDP ratio continues to rise. A source of grave concern which is noted in the BIS Quarterly Review, September 2016. At the end of July total Chinese debt reached $28trln – greater than the government debt of the US and Japan combined. Corporate debt, which is fortunately denominated primarily in local currency, now stands at 171% of GDP whilst total debt stands at 255%. A favourite BIS measure is the Credit to GDP gap. A figure above 10 is a warning signal that an economy may be approaching a “Minsky Moment” – China scores 30.1, the highest of any large economy.

China has also continued to reduce its vast foreign exchange reserves, although at a more moderate pace than in 2014 and 2015. In July it reduced its holding of US Treasuries by $22bln – the largest one month decline in three years. It also released information about its gold holdings which, as many market participants had predicted, have risen substantially – it last reported this information in 2009. The US Bond sales may, therefore, have been to insure the stability of the RMB versus the US$ ahead of the G20 summit which was hosted by China this month.

The only “solution” to excessive debt within the economy is to allocate the costs of that debt, and not to transfer it from one entity to another.

The recapitalization of the banks is nice, in other words, but it is hardly necessary if we believe, and most of us do, that the banks are effectively guaranteed by the local governments and ultimately the central government, and that depositors have a limited ability to withdraw their deposits from the banking system. “Cleaning up the banks” is what you need to do when lending incentives are driven primarily by market considerations, because significant amounts of bad loans substantially change the way banks operate, and almost always to the detriment of the real economy.

…If we change our very conservative assumptions so that debt is equal to 280% of GDP, and is growing at 20% annually, and that debt-servicing capacity is growing at half the rate of GDP (3.0-3.5%, which I think is probably still too high), then for China to reach the point at which debt-servicing costs rise in line with debt-servicing capacity, Beijing’s reforms must deliver an improvement in productivity that either:

Causes each unit of new debt to generate 18 times as much GDP growth as it is doing now, or

Causes all assets backed by the total stock of debt (280% of GDP) to generate 50% more GDP growth than they do now.

Meanwhile, the great rebalancing towards domestic consumption continues, at what, in other countries, would be considered break-neck speed. This may, nonetheless, be too slow for China – the mini-stimulus package, in April, was a clear political capitulation. The Kansas City Federal Reserve – Consumer Spending in China: The Past and the Future looks at the success of rebalancing to date and the prospects going forward. They point out that Chinese consumption as a share of GDP declined between 1970 and 2000 largely as a result of demographic forces – low birth rate and aging population – together with urbanisation. Post 2000 rapid house price appreciation accelerated this trend. Since 2010 consumption has begun to rise from a low point of 37% of GDP, this coincides with the peak in household savings at 42% – it is now around 38.5%. The authors predict:-

In a benchmark scenario of relatively stable income growth and a further modest decline in the household saving rate, consumption growth in China remains at around 9 percent per year over the next five years, causing the share of Chinese consumption in GDP to increase by about 5 percentage points to 44 percent by 2020. This scenario has two implications. First, it suggests that strong consumption growth is sustainable in the near future, allowing China to continue transitioning toward a consumption-driven economy. Second, it suggests that strength in near-term Chinese consumption growth will partly rely on a further decline in the household saving rate. As the household saving rate cannot decline indefinitely, consumption growth may need to rely more heavily on household income to be sustainable in the long run.

Parallels have been made with Japan where the savings rate has declined from 40% to 19% of GDP since 1970. If China follows this pattern, savings as a percentage of income will continue to decline. The transition could be relatively smooth provided the residential property market does not collapse in the interim. The FRBKC article concludes:-

The declining saving rate in China reflects both a changing demographic structure—an expected increase in the young dependency ratio after multiple decades of decline—and a changing consumption pattern of young people, who face less pressure to save thanks to financial support from their parents and grandparents.

In the long run, transitioning to a consumption-driven economy may require some policy changes. Specifically, China may need to implement successful supply-side reforms—which are on the government’s agenda but haven’t yet been significantly pushed forward—to enable domestic production to meet rising domestic demand. Although the Chinese household saving rate is declining from a very high level, the downward trend cannot last forever. A truly consumption-driven economy must rely on strong household income growth, which is ultimately driven by improved technology and investment.

In the long run, demographic forces will affect China more than any other factor. According to the Ministry of Human Resources China’s working population hit a record 774.5mln in 2015, however, the UN estimate China will have 212mln fewer workers by 2050. The UN Demographic Profile is found on page 189.

Market impact and investment opportunities

Next week the RMB will be included in the SDR – the Peterson Institute – China’s Renminbi Is about to Break the Financial Glass Ceiling discusses this in more detail. There is widespread speculation that the PBoC will widen the RMB currency bands at any moment. In other respects the PBoC is in a more difficult position. The RMB has already weakened by 5% against the US$ this year. Cutting interest rates would probably cause the currency to weaken further, riling the US voters ahead of the election. They are not impotent, however, and injected a record RMB 310bln into the money market in August – part of an overt policy to support the official banking sector, diminishing the influence of shadow banks.

Domestic investors have favoured bonds over equities for the past couple of months, while the spread between corporate bonds and government bonds has narrowed. Chinese 10yr government bond yields have fallen around 50bp this year, but official policy, encouraging investors to purchase higher yielding bonds and reduce their exposure to leveraged wealth management products and other non-standard assets, is boosting demand for corporate issues.

Retail investors, who were badly burnt in the stock market collapse of 2015, remain obsessed with the property market despite massive over-supply. Equity broker margin balances remain low. Institutional portfolio managers have reduced exposure to stocks from 62% in July to 49% this month. In the post-crash environment IPO issuance has been subdued with only RMB 955bln of capital raised in the seven months to July. This compares to RMB 1.55trln in 2015. The final quarter may see better sentiment. Stocks may get a boost from local government spending in Q3 and Q4 – if only to insure their budgets are not reduced next year. The table below, from Star Capital, ranks forty of the world’s major stock markets. Using their metrics, China is second cheapest and has the lowest PE, Price to Cash flow and Price to Book:-

Country

CAPE

PE

PC

PB

PS

DY

Rank

Russia

4.9

7.5

3.6

0.8

0.8

4.10%

1

China

12.4

6.1

3.2

0.8

0.6

4.70%

2

Brazil

8.5

44.1

6.6

1.4

1.1

3.40%

3

South Korea

12.6

11

5.5

1

0.6

1.80%

5

Hungary

9.9

?

5.1

1.2

0.6

2.80%

6

Czech

8.7

11.8

5.5

1.2

1

7.50%

8

Turkey

9.7

10.8

6.2

1.3

0.9

2.70%

9

Source: Starcapital.de

The Shanghai Composite Index (SHCOMP) is down 8.85% YTD and by 41.84% since its high in June 2015, however it is up 48.25% from June 2014. Russia’s RTS Index by contrast is up 72.81% from its December 2014 low but still 29.68% below its level of June 2014.

Looking outside China, several Australia-centric mining stocks have already risen on the back of the move in coking coal but it seems unlikely that the supply imbalance will prove protracted. Anglo American (AAL) is still looking to sell more of its Australian coal mines – they may well find Chinese buyers.

Outside of China, infrastructure investment across Asia Pacific is on the rise, which is supportive for industrial commodities in general. KPMG – 10 emerging trends in 2016, published in January, takes a very optimistic long term view:-

Ultimately, however, we believe that this may well be the tipping point that ushers in 50 years (or more) of prosperity as capital starts to match up with projects which, in turn, will drive economic growth in the developing world and shore up retirement savings in the mature markets.

Commodity markets tend to exhibit very individual characteristics, however, several industrial and agricultural commodities have formed a longer term base this year. Is this the beginning of the next commodity super-cycle? It’s too soon to call, but without a rise in global demand the prospects for substantial gains are likely to be limited – Indian GDP growth is slowing. The IMF WEO July update revised its India GDP forecast for 2016 to 7.4% from 7.5% – in 2015 it was 7.6%. Its China forecast was revised up 0.1% and its overall Emerging Market and Developing Economy forecast for 2016 and 2017 was unchanged at 4.1% and 4.6%, although, world economic growth was revised 0.1% lower.

China’s stock market remains cheap by many metrics, but the level of indebtedness is an impediment to economic growth. The property market, although over-supplied, continues to attract investment, but this is economically unproductive in the long run. Government policy is attempting to steer the economy towards higher domestic consumption and technologically driven, productivity enhancing, investments. Environmental issues are finally being addressed, yet the challenge of clean water remains substantial.

Near term, debt reduction – and it has yet to begin – will hamper growth, which will, in turn, reduce the attractiveness of Chinese stocks. Reform of the SOEs will involve consolidation into a smaller number of vast enterprises. Private enterprises will suffer. “Zombie” companies will start to be dealt with as bankruptcy procedures become standardised, but, as with all policy in China, a gradualist approach is likely to be implemented. Commodity markets may continue to rise due to supply side factors but I doubt that Chinese demand will rebound even to the level of 2013/2014, let alone the early part of the century.

Oversupply in real-estate is still a concern but lower interest rates are helping

Infrastructure spending may help and Chinese stocks are cheap

I was prompted to write this rather longer letter by the recent weakness of the Chinese currency. The chart below tracks the progress of the USDCNY over the last three years, compared with many emerging markets the devaluation is minimal:-

Source: Trading Economics

A longer term chart shows how far the currency has travelled over the last 12 years:-

Source: Trading Economics

It was at the National People’s Congress of March 2013 that the policy of “rebalancing” was introduced, however, the CNY continued to strengthen. This gradual appreciation against the US$ had created large imbalances within the Chinese economy. The economic-policy adjustment of “rebalancing” had one objective: shifting China from a production-oriented economy to one focused on household consumption. If, in the process, it could alleviate international pressure on the Chinese administration to allow the CNY to float freely, so much the better. Now it looks as if the outcome of allowing the CNY to float freely would see it sink like a stone.

China’s leadership is well aware of the limitations of the producer-biased and export-led model. Interestingly, there is no major disagreement between the Chinese and the international community about the need for rebalancing policies to ensure China’s smooth transition to a more sustainable model. The disagreement is more about how fast the reform measures should be implemented.

It has been argued that intertwined economic and political interests make China’s rebalancing more difficult and cause the reform process to advance slowly. Political resistance to the reforms stems from various sources. First, in a system where political success at the local level has been historically dependent on quantitative growth, reforms that emphasise the quality of growth are bound to meet some resistance. Second, the current growth model required to keep some strategic sectors of the economy closed and under state control (e.g. financial markets, services, heavy industry). The planned opening up of these sectors to competition does not only meet resistance from SOEs and banks, but is also questioned in government circles owing to worries about exhausting the “privilege” of direct macroeconomic policy management. Not surprisingly, major resistance is observed in the export lobby, which is one of the most influential in China and the one which reforms affect most directly.

Of course, there is no guarantee that rebalancing will succeed. Part of the problem is that the politics associated with it—boosting the income of Chinese households at the expense of state-owned companies and other large investment-oriented entities—is actually more complicated than the economics. But one thing is certain. China is rapidly reaching the point of diminishing economic and political returns from its investment-driven model, which is headed for change one way or another: either through a proactive rebalancing, with reforms and policy adjustments, or a forced rebalancing precipitated by rising stresses in and beyond the financial system. So far, the signs are encouraging that the new leadership is serious about changing China’s growth model, and this is reason enough for global firms that have benefited from China’s investment boom to rethink their strategies for the years ahead.

Three years on the challenges of rebalancing an $11trln economy of 1.4bln people are becoming evident. McKinsey – China’s Choice – Capturing the $5 Trillion Productivity Opportunity, published last month, makes the case for continued reform based on boosting productivity:-

…Government can do a great deal to improve the odds of success by transforming institutions in six priority areas:

I. Open more sectors up to competition. SOEs still account for 43 percent of service sector fixed-asset investment, compared with 8 percent in manufacturing

.…In telecommunications, for instance, an effort to introduce mobile virtual network operators to target underserved segments has not yet had a substantial impact because the big three players in the sector still have considerable clout in negotiations and strong influence on pricing. In health care, fixing the economics model to make hospitals less dependent on drug sales and encourage more qualified doctors to work at private hospitals could help improve the quality of service.

II. Improve the breadth and quality of capital markets. China would benefit from a financial system where market forces allocate capital efficiently; that means well functioning bond and equity markets that attract a diverse set of investors, including institutional and overseas players. The municipal bond market could lower financing costs for local government while bringing market discipline to managing investment projects. To facilitate this shift, China needs to strengthen the foundations of an effective financial system, such as strong, independent credit-rating agencies, more transparent public data on the economy, and more effective communication about government monetary policy. Inviting new players (such as internet banks) to supply capital and helping banks build capabilities to undertake more lending for underserved segments such as small and medium-sized enterprises and rural consumers will be important.

III. Enable corporate restructuring. Shifting successfully to a productivity-led growth model will mean a sea change—letting inefficient companies fail rather than protecting and propping them up and rationalizing excess capacity.

…enforcing bankruptcy law and improving the bankruptcy process. Strengthening capabilities of asset-management companies tasked with handling restructuring could help to turn around companies in default. China will need to expand the securitization of non-performing loans to be prepared for any larger-scale bad debt situation and to ensure that banks put effective risk management in place.

IV. Invest in talent and enhance labor mobility. China has made great strides in educating its people, but more is needed. Among the measures that the government could now take are providing more funding for education, designing programs that rotate effective teachers to places they are most needed, and engaging the private sector to define job-ready skills, build those into curricula, and establish an education to-employment pipeline. On top of this, the government could enhance labor mobility to optimize employment across different regions of the country. Expansion of unemployment insurance and training can help smooth the transition for displaced workers and help them back into jobs. Ensuring gender equality in opportunities in education and in the labor market, while supporting women as well as men as they develop their careers, can further strengthen China’s talent base.

V. Boost aggregate demand. As inequality grows, the government can revise fiscal and tax policies to give households more spending power. For families in need, it could consider conditional cash transfers. Improving social safety net programs by raising health-care and retirement benefits, for example, can reduce the need for precautionary saving for out-of-pocket medical expenses, facilitate consumption, and reduce income inequality. Broadening affordable-housing programs to include migrant workers, with market-based subsidies on both the supply and demand side, can also help low-income families to consume more.

VI. Improve public-sector effectiveness. Ensuring that government raises its own productivity is an important part of any transition to a productivity-led model. Such an effort can start by using household income and productivity indicators to evaluate officials and departments rather than rewarding them largely for the GDP growth their cities or regions achieve. Digitizing government operations and service delivery is an important part of the mix. Government also needs to develop better conflict-resolution capabilities to mediate between different stakeholders so that restructuring and reforms can proceed.

Another aspect of President Xi’s reform is in foreign policy, it has been dubbed the “One Belt, One Road” (OBOR). Last week the Economist – Our bulldozers, our rules discussed the potential of the initiative:-

…Asia needs new infrastructure—about $770 billion a year of it until 2020, according to the Asian Development Bank. This demand should eventually ease today’s worries about a lack of projects. Bert Hofman, the World Bank’s chief in Beijing, adds that individual countries will benefit more if they align their plans with one another and with China. It does not pay to plan and build separately.

Next, China needs OBOR. At home, its businesses are being squeezed by rising costs and growing demands that they pay more attention to protecting the environment. It makes sense for them to shift some manufacturing overseas—as long as the infrastructure is there.

Lastly, Xi Jinping needs it. He has made OBOR such a central part of his foreign policy and has gone to such lengths to swing the bureaucracy behind the project that it is too late to step back now.

None of this means the new Silk Road will be efficient, nor does it mean China’s plans will always be welcome in countries suspicious of its expanding reach. But the building blocks are in place. The first projects are up and running. OBOR is already beginning to challenge the notion of Europe and Asia existing side by side as different trading blocs.

This is reminiscent of the economic development of Japan during the 1970’s and 1980’s.

Despite these policy initiatives, the Chinese economy has been slowing for the past six years. An excellent overview of the current situation was provided last month by the China-United States Exchange Foundation – China’s Incomplete Growth Strategy, in which they highlighted the policies for and challenges to achieve growth, both in the long and short run. Most of the problems are associated with the oversupply evident in the real-estate market and the economic drag from the debt associated with this over-supply. Their solution, as McKinsey suggested above, is infrastructure development:-

…last November, they officially placed the blame on long-term supply-side shortcomings, which they pledged to address with far-reaching structural reforms.

Among the long-term factors undermining potential growth are diminishing returns to scale, a widening income gap, and a narrowing scope for technological catch-up through imitation. Moreover, even as the country’s demographic dividend dissolves, its carrying capacity (the size of the population the environment can sustain) is being exhausted – a situation that high levels of pollution are certainly not helping. Finally, and most important, the country is suffering from inadequate progress on market-orientated reform.

While some of these factors are irreversible, others can be addressed effectively. And, indeed, the government’s supply-side reform strategy will go a long way toward doing just that, ultimately stabilizing and even raising China’s growth potential. But, contrary to popular belief, they will not boost China’s actual growth rate today.

Why are so many economists convinced that a long-term reform strategy is all China needs? One reason is the widely held notion that today’s overcapacity reflects supply-side problems, not insufficient demand. According to this view, China should implement policies like tax cuts to encourage companies to produce products for which there is genuine demand. That way, the government would not inadvertently sustain “zombie enterprises” that cannot survive without bank loans and support from local governments.

But only some of China’s overcapacity can be attributed to bad investment decisions. A large share has emerged because of a lack of effective demand. And that is, at least partly, a result of the government’s effort to moderate real-estate investment, which has caused the sector’s annual growth to tank, plunging from 38% in 2010 to 1% at the end of 2015.

With real-estate investment still accounting for more than 14% of GDP last year, plummeting growth in the sector has put considerable downward pressure on the economy as a whole, helping to push China into a debt-deflation spiral. As overcapacity drives down the producer price index – which has now been falling for 51 consecutive months – real debt rises. This is undermining corporate profitability, spurring companies to deleverage and reduce investment, and fuelling further declines in PPI.

The enduring importance of real-estate investment to China’s economic growth is reflected in trends from the first quarter of this year. Annual GDP growth of 6.7%, despite being the slowest rate for any quarter in seven years, exceeded market expectations. And it was driven partly by an unforeseen increase in real-estate investment growth, to 6%.

This is not to say that what China needs is more real-estate investment. According to the National Bureau of Statistics, China had 718 million square meters of unsold commercial and residential floor space at the end of 2015; when space under construction is factored in, inventory expands to more than five billion square meters. With an average of only 1.2 billion square meters of housing being sold each year, the best way to reduce this supply glut is clear: limit future construction. One of the most important reasons for the recent investment surge was abundant liquidity driving speculative demand – and that is hardly sustainable.

…Infrastructure investment, in particular, may well be the key to tackling China’s economic woes. After all, such investment, which grew at 19.6% in the first quarter of 2016, has already proved to be a critical driver of economic growth – and, unlike real-estate investment, it has not worsened China’s resource allocation or set the stage for major imbalances.

When there is slack in the economy, the only way to escape the debt-deflation trap is to grow strongly. Given that China is saddled with large local-government and corporate debts, but also enjoys large domestic savings and a strong fiscal position, this message could not be more pertinent. In an ideal world, domestic consumption would serve as the main engine of growth; under current circumstances, infrastructure investment is the most reliable option.

In the short term, when overcapacity and deflation are the main obstacles, infrastructure investment boosts growth through the economy’s demand side. In the long run, it operates through the supply side to boost productivity and thus raise growth potential. China can fund such investment with fiscal deficits, given strong demand for government bonds. And, with China’s major banks still state-owned, and capital controls still in place, the risk of an imminent financial crisis is very low.

Of course, China’s government must uphold its commitment to implement structural reforms. But infrastructure investment is also badly needed, not just to prevent the economy from sliding further, but also to enable China to generate the sustained long-term growth that it requires to achieve developed-country status.

The slowdown in Chinese growth has finally prompted concerns around the world. In their May Economic Letter, the Dallas Fed – Impact of Chinese Slowdown on U.S. No Longer Negligible noted that the knock on effect of slowing Chinese growth had taken 20% off US GDP. The chart below shows Chinese and US annual GDP growth over the last 10 years, China is the left hand scale, the negative impact of Chinese growth on US GDP since 2010 has been roughly 0.4%:-

Source: Trading Economics

The Problem of Debt

The current environment in China – as it is in much of the rest of the world – is dominated by the incessant increase in debt. In May, in what many observers regard to be a reversal of their opinion on the dangers of China’s debt mountain, the Economist – The coming debt bust attempted to quantify the magnitude of the problem facing the Chinese financial system:-

China was right to turn on the credit taps to prop up growth after the global financial crisis. It was wrong not to turn them off again. The country’s debt has increased just as quickly over the past two years as in the two years after the 2008 crunch. Its debt-to-GDP ratio has soared from 150% to nearly 260% over a decade, the kind of surge that is usually followed by a financial bust or an abrupt slowdown.

China will not be an exception to that rule. Problem loans have doubled in two years and, officially, are already 5.5% of banks’ total lending. The reality is grimmer. Roughly two-fifths of new debt is swallowed by interest on existing loans; in 2014, 16% of the 1,000 biggest Chinese firms owed more in interest than they earned before tax. China requires more and more credit to generate less and less growth: it now takes nearly four yuan of new borrowing to generate one yuan of additional GDP, up from just over one yuan of credit before the financial crisis. With the government’s connivance, debt levels can probably keep climbing for a while, perhaps even for a few more years. But not for ever.

When the debt cycle turns, both asset prices and the real economy will be in for a shock. That won’t be fun for anyone. It is true that China has been fastidious in capping its external liabilities (it is a net creditor). Its dangers are home-made. But the damage from a big Chinese credit blow-up would still be immense. China is the world’s second-biggest economy; its banking sector is the biggest, with assets equivalent to 40% of global GDP. Its stockmarkets, even after last year’s crash, are together worth $6 trillion, second only to America’s. And its bond market, at $7.5 trillion, is the world’s third-biggest and growing fast. A mere 2% devaluation of the yuan last summer sent global stockmarkets crashing; a bigger bust would do far worse. A mild economic slowdown caused trouble for commodity exporters around the world; a hard landing would be painful for all those who benefit from Chinese demand.

Brace, brace

Optimists have drawn comfort from two ideas. First, over three-plus decades of reform, China’s officials have consistently shown that once they identified problems, they had the will and skill to fix them. Second, control of the financial system—the state owns the major banks and most of their biggest debtors—gave them time to clean things up.

Both these sources of comfort are fading away. This is a government not so much guiding events as struggling to keep up with them. In the past year alone, China has spent nearly $200 billion to prop up the stockmarket; $65 billion of bank loans have gone bad; financial frauds have cost investors at least $20 billion; and $600 billion of capital has left the country. To help pump up growth, officials have inflated a property bubble. Debt is still expanding twice as fast as the economy.

…“shadow assets” have increased by more than 30% annually over the past three years. In theory, shadow banks diversify sources of credit and spread risk away from the regular banks. In practice, the lines between the shadow and formal banking systems are badly blurred.

That creates two risks. The first is higher-than-expected losses for the banks. Hungry for profits in a slowing economy, plenty of Chinese banks have mis-categorised risky loans as investments to dodge scrutiny and lessen capital requirements. These shadow loans were worth roughly 16% of standard loans in mid-2015, up from just 4% in 2012. The second risk is liquidity. The banks have become ever more reliant on “wealth management products”, whereby they pay higher rates for what are, in effect, short-term deposits and put them into longer-term assets. For years China restricted bank loans to less than 75% of their deposit base, ensuring that they had plenty of cash in reserve. Now the real level is nearing 100%, a threshold where a sudden shortage in funding—the classic precursor to banking crises—is well within the realm of possibility. Midsized banks have been the most active in expanding; they are the place to look for sudden trouble.

Pandamonium

The end to China’s debt build-up would not look exactly like past financial blow-ups. China’s shadow-banking system is big, but it has not spawned any products nearly as complex or international in reach as America’s bundles of subprime mortgages in 2008. Its relatively insulated financial system means that parallels with the 1997-98 Asian crisis, in which countries from Thailand to South Korea borrowed too much from abroad, are thin. Some worry that China will look like Japan in the 1990s, slowly grinding towards stagnation. But its financial system is more chaotic, with more pressure for capital outflows, than was Japan’s; a Chinese crisis is likely to be sharper and more sudden than Japan’s chronic malaise.

One thing is certain. The longer China delays a reckoning with its problems, the more severe the eventual consequences will be. For a start, it should plan for turmoil. Policy co-ordination was appalling during last year’s stockmarket crash; regulators must work out in advance who monitors what and prepare emergency responses. Rather than deploying both fiscal and monetary stimulus to keep growth above the official target of at least 6.5% this year (which is, in any event, unnecessarily fast), the government should save its firepower for a real calamity. The central bank should also put on ice its plans to internationalise the yuan; a premature opening of the capital account would lead only to big outflows and bigger trouble, when the financial system is already on shaky ground.

Most important, China must start to curb the relentless rise of debt. The assumption that the government of Xi Jinping will keep bailing out its banks, borrowers and depositors is pervasive—and not just in China itself. It must tolerate more defaults, close failed companies and let growth sag. This will be tough, but it is too late for China to avoid pain. The task now is to avert something far worse.

The extensive credit expansion in January and February, especially from the banking sector, has several implications. First, it masks the growth of the non-performing loan ratio as the denominator has experienced such a big increase. Second, such surge in credit granted must have had a surge in demand as well. Whether that new demand reflects an improvement in the economy or simply more financing needs is a key question. If it is the latter then it reflects an increasing demand for new funds to repay outstanding loans.

Having said that, China had a bad-loan coverage ratio of 150%, which is considered high for international standards. However, there is rumor that this will be lowered to 120%. In any event, credit risk is rapidly rising in China as the economy slows down and financial conditions are lax enough for corporates to continue to leverage. The question, thus, is how weak are Chinese banks in the current circumstances.

There is no way Beijing can address the debt without a sharp drop in GDP growth, but as unwilling as Beijing may be to see much lower growth, it doesn’t have any other option. It must choose either much lower but manageable growth today or a chaotic decline in growth tomorrow. The debt burden cannot stop rising, in other words, until Beijing adjusts its growth expectations sharply downwards and forcefully implements the kinds of reforms that the XI administration has talked about implementing, albeit against powerful political opposition, since the Third Plenum of October 2013.

Pettis then produces a set of scenarios, firstly with growth remaining at current levels:-

Growth remains at 6-7%

2016 -2019

2020-2023

No government transfers

· Debt growth is steady at 12-14%

· Investment growth is steady at current levels

· Consumption growth is steady at current levels

· Growth in household income is steady and household share of GDP is unchanged

· No rebalancing

· Period begins with 25% higher debt-to-GDP ratio, and consumption and investment account for roughly equal shares of GDP

· Debt growth rises to 15-18%

· Investment growth is steady at current levels

· Consumption growth is steady at current levels

· Growth in household income is steady and household share of GDP is unchanged

· Period begins with 10-15% higher debt-to-GDP ratio, and consumption exceeds investment as a source of growth

· Debt growth rises to 11-13%

· Investment growth declines by another percentage point

· Consumption growth is steady

· Growth in household income is steady and household share of GDP rises

· Gradual rebalancing

Growth remains at 6-7%

2016 -2019

2020-2023

Annual government transfers of 3-4% of GDP

· Debt growth drops to 8-10%

· Investment growth declines by 6-7 percentage points

· Consumption growth rises by 6-7 percentage points

· Growth in household income rises by 6-7 percentage points and household share of GDP is materially higher

· Material rebalancing

· Period begins with 5-10% higher debt-to-GDP ratio, and consumption significantly exceeds investment as a source of growth

· Debt growth rises to 6-8%

· Consumption growth declines by 1-2 percentage points

· Growth in household income declines by 1-2 percentage points and household share of GDP is materially higher

· Material rebalancing

Next, Pettis looks at the same scenarios adjusting growth lower:-

Growth drops to 3-4%

2016 -2019

2020-2023

No government transfers

· Debt growth drops to 6-8%

· Investment growth declines by 4-6 percentage points

· Consumption growth declines by 2-4 percentage points

· Growth in household income declines by 2-4 percentage points and household share of GDP is slightly higher

· Material rebalancing

· Period begins with 10-15% higher debt-to-GDP ratio, and consumption exceeds investment as a source of growth

· Debt growth is steady at 6-8%

· Investment growth is steady at current levels

· Consumption growth is steady at current levels

· Growth in household income is steady at current levels and household share of GDP is materially higher

· Material rebalancing

Growth drops to 3-4%

2016 -2019

2020-2023

Annual government transfers of 1-2% of GDP

· Debt growth drops to 5-6%

· Investment growth declines by 7-9 percentage points

· Consumption growth is flat

· Growth in household income is flat and household share of GDP is higher

· Material rebalancing

· Period begins with slightly higher debt-to-GDP ratio, and consumption significantly exceeds investment as a source of growth

· Debt growth is steady at 5-6%

· Investment growth is steady at current levels

· Consumption growth is steady at current levels

· Growth in household income is steady at current levels and household share of GDP is materially higher

· Material rebalancing

Growth drops to 3-4%

2016 -2019

2020-2023

Annual government transfers of 3-4% of GDP

· Debt growth drops to close to zero

· Investment growth is zero

· Consumption growth rises from current levels

· Growth in household income rises from current levels and household share of GDP is materially higher

· Substantial rebalancing

· Period begins with lower debt-to-GDP ratio, and consumption significantly exceeds investment as a source of growth

· Debt growth drops to well below GDP growth

· Investment growth is steady at current levels

· Consumption growth is steady at current levels

· Growth in household income is steady at current levels and household share of GDP is substantially higher

· Substantial rebalancing

Pettis concludes:-

A massive debt burden significantly reduces the options available to policy-makers and a severely unbalanced structure of demand forces policy-makers to choose between rising unemployment, rising debt, or rising wealth transfers. Economists who do not understand how this fairly simply trade-off dominates all policymaking simply will not be able to provide useful policy advice.

Conclusion and Investment Opportunities

China, like many other countries has a problem with debt. The FT recently published an estimate that the Chinese debt to GDP ratio was only 237% (lower than the Economist’s 260%) and government debt to GDP is only 43.9%, whilst household debt to GDP is 39.5%. The Heritage Foundation – Index of Economic Freedom 2016 – estimates China’s government spending to GDP at 29.3%, below that of many developed nations. The Rahn curve below shows how government spending can help to accelerate growth but the diminishing return once it rises above 15% of GDP:-

Source: The Heritage Foundation, Peter Brimelow

Nonetheless, China compares favourably with Japan where government spending is 40.2%.

Stocks, Bonds and the Currency

The Shanghai Composite, shown below, has turned higher since the middle of May. A break above 3,075 could see it retest the highs of 2015 but this is unlikely to be the policy of the Xi administration:-

Source: Trading Economics, Shanghai Stock Exchange

10 year Chinese Government bonds have declined in yield as a result of the international turmoil created by Brexit, but, unlike many of major, international government bonds, they have not made new lows so far:-

Source: Trading Economics, Chinese Ministry of Finance

I believe the recent rally in stocks is a function of the lower yield on bonds. The Chinese government has the whip hand. During the rally and subsequent collapse in the stock market during 2015, the government did not respond in a coordinated manner. Amongst a plethora of initiatives, and I may well have missed some, they relaxed margin requirements, fuelling the speculative bubble, then, as the shake out gathered momentum, suspended the trading in shares listed on multiple markets. As liquidity conditions became more severe they froze 38 individual trading accounts – including certain algorithmic liquidity providers. The regulators also banned short selling and margin loans enabling investors to sell short on T=) settlement. They forced certain brokers to execute buy orders; one broker was bailed out with a CNY 260bln cash injection.

The rules on insurance companies purchasing stock were relaxed, certain shareholders (specifically SOE’s) were prohibited from selling and, under Announcement 18, senior managers and major shareholder (ones holding a stake of 5 % or more) were threatened with “severe punishment” if they sold shares of any listed company during a period of six months. IPO issuance was also suspended – a recent article from the FRBSF – China’s IPO Activity and Equity Market Volatility looks at possible reforms of the IPO market. The authorities will not want to make the same mistakes a second time.

Margin lending has, so far, remained subdued. The chart below has data up to March 2016. Chinese investors were wounded last year but 10 year bond yields have fallen 80bp since June 2015:-

Source: Wind Information Co, WSJ

Returning to the first chart, tracing the fortunes of the CNY, China appears to be exporting its way out of trouble at the expense of its trading partners. Its largest export market is the EU, US followed by Japan and South Korea. Here is the US census bureau data for US-China trade since 2008:-

Under the new method, the size of the economy is larger than previously estimated; 2015 GDP was revised up by 1.3% to 11tn USD, the Real growth rate was also revised up (rates vary from year to year and averaged 0.06% (6 bps) over the past 5 years). The upward revision is because China’s R&D expenditure growth has been consistently faster than that of overall GDP–though the difference the change makes to the GDP growth rate is small as R&D is a small part of the economy. The NBS announced 1Q real growth was revised up by 0.04% (4bps), but it did not specify whether the growth rate is now 6.8% yoy or remains at 6.7% yoy. We believe the latter case is slightly more likely as an upward revision would have been highlighted. A higher trend level would mean 2Q GDP growth should be higher as well. As a result, we revise our Q2 real GDP growth forecast to 6.7% yoy from 6.6% yoy previously with slight upside risk to our full-year forecast of 6.6% yoy.

Whether the markets are taken in by this sleight of hand remains to be seen, but, when statisticians are making comparisons in a couple of years from now, the higher growth rate will most likely be taken as gospel.

Chinese stocks, meanwhile, are cheap relative to many other markets. As at the end of June the CAPE was 12.4, PE 6.1 – the lowest of any major stock market globally, PC 3.2, PB 0.8, PS 0.6 and the dividend yield was 4.7%. Only the differential between the dividend yield and the 10 year bond yield (1.93%) looks unremarkable.

Chinese Q2 GDP data is released next week, an unnamed official suggested the PBoC might still have room to cut interest rates, although any further loosening of bank reserve requirements appears unlikely. As we head into the summer lull, Chinese stocks, especially those with an exposure to infrastructure, may offer an excellent buying opportunity.